Restructuring Experts: Dump Kmart to Save Sears

If hedge fund manager Eddie Lampert wants to save one of the oldest retail empires in the United States, he should consider shutting down Sears Holdings Corp.'s Kmart discount chain and focus on revamping its Sears department stores.

Such is the advice of half a dozen retail executives and restructuring experts who have watched the company's sales shrink every year since 2005, when Lampert formed Sears Holdings by combining two of the most iconic American chains in an $11 billion deal.

After a dismal showing this holiday season due to dowdy merchandise, run-down stores and a reputation for poor service compared with rivals such as Macy's and Target, the retailer last week said it would close 100 to 120 of its 3,500 U.S. stores. The news wiped more than a quarter off Sears Holdings' market value, which now stands at just $3.4 billion.

The company needs to take much more radical action to turn around its business, the experts said, pointing to 18 straight quarters of sales declines and Lampert's propensity to spend company cash on buying back shares instead of upgrading stores. His ESL Investments Inc. owns 45 percent of Sears Holdings.

"Trimming down a hundred stores is like rearranging deck chairs on the Titanic," said Craig Johnson, president of retail strategy and consulting firm Customer Growth Partners, whose clients include J.C. Penney Co. Inc. and Toys R Us. "This is a company that needs not just cosmetic surgery, not just minor surgery, but radical surgery."

Johnson and others said Sears Holdings should close as many as 1,000 stores to cut costs and recoup what it can from selling off inventory and related real estate. Then, it needs to significantly revamp its remaining stores and expand its online business to reverse its years long decline.

Such a culling would be very painful, likely resulting in layoffs for tens of thousands of the company's 280,000-strong U.S. workforce and loss of the major retail store in some communities, according to retail specialists.

Once the largest U.S. discount chain, Kmart has declined over the years as it has been unable to keep up with Wal-Mart's low prices and Target's more upscale though still affordable offerings. Kmart went bankrupt nearly a decade ago and never fully recovered — its 2010 sales of $15.6 billion were only about 5 percent of Wal-Mart's U.S. sales.

"In a world that has Wal-Mart and Target, there is really no need for a Kmart," said Roger Goddu, who was CEO of the Montgomery Ward department store chain, which went out of business in 2001.

"The one I would choose to save is Sears," said Goddu, now a partner in private equity firm Brentwood Associates.

Kmart accounted for about 36 percent of the company's sales in 2010 but only 32 percent of gross profit, reflecting the discount retailer's thinner margins compared with Sears. Restructuring experts said it was difficult to estimate how much Kmart would be worth if it was liquidated because the company does not break out inventory by business unit, and the value of its roughly 1,300 stores would depend on when leases expire.

Sears Holdings declined to comment specifically on the future of Kmart, but said the company was an "asset rich enterprise" with well over $3.5 billion of liquidity.

HISTORIC BRAND

For those trying to predict the future of Sears Holdings, one key date is Feb. 23, when the company will report annual results. Lampert typically publishes a letter to shareholders at around that time.

Investors lost 56.6 percent on their Sears' stock last year. It hit $193.98 in April 2007, but ended 2011 at just $31.78.

Sears was once one of the most successful U.S. retailers with a history going back to 1886, when Richard Sears began to sell watches as a train station agent in North Redwood, Minnesota. Its sprawling empire had included a radio station in Chicago, Allstate Insurance Co., and Chicago's Sears Tower, the world's tallest building when it was completed in 1973.

The department stores were beloved by generations of Kenmore appliance buyers, while the do-it-yourself crowd scooped up Sears' Craftsman tools. But the company has let its stores deteriorate over the years, say critics, who also faulted poor locations and ho-hum merchandise.

Sears Holdings is now the tenth largest U.S. retailer, with annual sales of $43.3 billion in 2010, down from $53 billion in 2006. Analysts expect it to post an annual loss for the first time in 2011, as their average estimate for fourth quarter net profit of $105 million will not fully offset the $743 million loss that it reported for the first nine months.

Sears Holdings worried Wall Street last week by announcing a 5.2 percent drop in sales at established stores in the 8 weeks leading up to Christmas. It also said that it tapped its credit line, something that alarmed investors since retailers are typically flush with cash during the holiday season.

Fitch saw rising risk that Sears Holdings' earnings before interest, tax, depreciation and amortization (EBITDA) could turn negative in 2012, and said it may need to restructure.

"If Sears is unable to access the capital markets or find other adequate sources of availability, and EBITDA remains at the current rate or lower, there is a heightened risk of restructuring over the next 24 months," Fitch said. A CCC rating is defined by Fitch as indicating substantial credit risk, with default a real possibility.

He noted that Sears Holdings had roughly $700 million in cash and $2.9 billion available on its credit facilities. It also has historically had between $8 billion and $10 billion of inventory and a substantial real estate portfolio, he added.

VENDORS KEY

A Sears Holdings' collapse is not seen likely in the near future. But that could change if key vendors lose faith and demand cash on delivery, decide to ship in smaller quantities, or ask for letters of credit, according to bankruptcy experts.

"The hurdle is going to be when one of the suppliers for a category that is important to them says we want letters of credit to back our receivables, at which point the unused bank lines get used very fast," said John Hempton, chief investment officer of a small hedge fund, Bronte Capital, in Australia. He has a short position on Sears.

Whirlpool Corp. and LG Electronics Inc. said there were no changes in their business ties with Sears and declined to comment on payment terms. Other suppliers General Electric Co., Newell Rubbermaid Inc. and Stanley Black and Decker Inc declined to comment.

Whirlpool Corp. spokeswoman Kristine Vernier said, "We have had a long history with Sears and expect to continue a productive relationship going forward."

Turnaround expert Gene Baldwin of CRG Partners, a restructuring firm, said that if Sears Holdings' sales continue to decline, large vendors, particularly in consumer electronics, will tighten credit to the company within a couple of years.

"One day, one of the large vendors will say: 'You know, I don't believe this story any more' ... and that will start a snowball of vendor activity," he said.

While he called the situation at Sears "very dire," others are more optimistic about the retailer, saying it can be revived if Lampert brings in a top executive with extensive retail experience. Since he owns nearly half of Sears, Lampert has more reason than most chairmen to avoid bankruptcy.

WANTED: RETAIL GENIUS

Lampert has been criticized for tumult in the executive suite. The retailer in February named Lou D'Ambrosio as its CEO after a three-year search, appointing a technology executive with no retail experience. Sears also appointed a new chief financial officer in the past year, and lost its marketing chief at the start of the holiday season.

Sears could use the Midas touch of someone like Mickey Drexler, a legend in the industry for building up the Gap brand in the 1990's and working his magic at J. Crew where he has been CEO since 2003, said retail consultant Mark Freiman of Focus Management Group, a financial advisory and restructuring firm.

"They have got some iconic brands that if they had the capital behind them and the right merchants in the company, they could be turned around," said Freiman, who was the chief executive of a franchise chain of retail Hallmark stores.

Some analysts said Lampert's tight control over the company made it less attractive to top talent, and it would be difficult for Sears to land someone like Apple Inc.'s ex-retail chief Ron Johnson who joined J.C. Penney last year as its CEO.

One area which retail experts say Sears has done well on is its website Sears.com, considered to be among the best operated by department stores. But they say the online brand has been damaged by shabby bricks-and-mortar stores.

Sears Holdings spent $441 million on capital expenditure in 2010, which includes spending on technology as well as remodeling stores. In comparison, Macy's spent $505 million and it has only 850 stores.

"It's almost a white flag — by letting your stores degrade, you're saying you're not planning to stay long term," said David Berliner, a partner in BDO Consulting's restructuring practice.

Going back to fiscal 2006, Sears Holdings has spent about $2.7 billion on capital expenditures, half the $5.4 billion that the company has spent to buy back shares.

QUESTIONABLE REAL ESTATE

When Lampert engineered the merger, he touted the value of the real estate of the chains. Kmart's stores are primarily leased. About 61 percent of Sears' 800 mall stores are owned, while the others are under longer term leases.

That value has declined over the years as high-profile retail bankruptcies pushed up vacancies in U.S. shopping malls. The average vacancy rate for large U.S. shopping malls hit an 11-year high in the third quarter of 2011.

"There isn't a whole lot of need for empty big boxes right now," said Craig Boucher, another turnaround expert at CRG. "We still have empty Circuit City stores and empty Linens N Things stores out there," he said in reference to two chains that closed in recent years.